Wednesday, October 17, 2012

Ultra transparency solves problem with accounting rules

In a Guardian article, Jill Treanor discusses how accounting rules, specifically the inability to recognize a loss on bad debt before it happens, is holding back bank stock valuations.

Regular readers know there is a very simple cure for this problem.  Require the banks to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants could independently assess the bad debt and adjust their valuation and the bank book capital level accordingly.  Problem solved.
The stock market value of banks is lower than the value of the assets on their books as current rules do not allow firms to make predictions about their future losses. 
A recurring theme among policymakers in the banking arena is the accounting rules used to value bank's bad debts. 
The markets are clearly concerned about this as the stock market value of banks is lower than the value of the assets on their books. It is evidence of a lack of confidence about the true worth of banks. 
Actually, this is recognition of the simple fact that regulators have allowed the banks to create zombie loans by engaging in extend and pretend.

The market is simply saying that it thinks the true worth of banks is dramatically lower than banks' currently overstated book capital levels.

The fact that banks trade at a sizable discount to meaningless book capital levels is inconvenient for the policymakers and financial regulators.  It says that market participants do not believe the policymakers and financial regulators' statements about the 'strength' of the banks.
The problem? The current rules do not allow banks to make predictions about their future losses and only account for the losses they have incurred. Tim Bush of investor body Pirc explained that banks cannot even take provisions for losses they know will incur in
the future.
By requiring the banks to provide ultra transparency, this problem goes away as the market participants make predictions about future losses and adjust book capital levels accordingly.
The topic was raised by two key policymakers at Wednesday's British Bankers' Association annual conference.  
Paul Tucker, deputy governor of the Bank of England, even went so far as to say that the time might have come to "disregard" accounting rules and adopt a "common sense" approach for regulatory purposes.
The common sense approach is to have the banks provide ultra transparency.  The market is much better than the regulators at figuring out the value of a bank's loan portfolio.
Andrew Bailey, the head of the Prudential Regulation Authority..., talked about the "possible shortfall in asset values relative to their book value which is exacerbated by the accounting standards preventing provisions being taken against expected future losses". 
Bailey added: "If the market value diverges from the tangible book value we know that investors are likely to be at least unsure that a firm's net assets are valued correctly in the published accounts."
Investors know that bank tangible book value is meaningless.

The question that investors have is what is the level of bank book capital if the banks were required to take upfront all the losses on the bad debt they are exposed to.

It has been clear since the beginning of the financial crisis that for the largest banks their book capital levels would be negative.
So if the policymakers are talking about the problem, it is time perhaps for something to be done about it.
Yes.  Require the banks to provide ultra transparency.

By not requiring banks to provide ultra transparency, policymakers and financial regulators are waving a big red flag that says the banks have something to hide.

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